The SEC and FINRA continue to pursue actions against brokers and clearing firms for failures in anti-money laundering (AML) controls and defects in filed suspicious activity reports (SARs) and failures to file SARs. In April I reported that the SEC had fined Aegis Capital for failures to file SARs related to the company’s penny stock business. Since then there have been a few SAR enforcement actions worth noting.
Chardan Capital LLC & Industrial and Commercial Bank of China Financial Services LLC (ICBCFS)
On May 16, 2018 the SEC announced settlements with Chardan Capital LLC and ICBCFS. The same day, FINRA announced a $5.3 million settlement with ICBCFS. At least in part, these settlements relate to failure to file SARs for penny stock transactions. I look in more detail at each settlement below.
FINRA fine of ICBCFS
The FINRA letter of acceptance, waiver, and consent with ICBCFS (pdf) gives detailed descriptions of the failings of ICBCFS’ systems and controls. There are many problems mentioned in the FINRA lettter, including “inadequate AML testing,” “customer reserve hindsight deficiencies,” “inaccurate books and records,” “inaccurate segregation calculations and possession or control violations,” “innacurate FOCUS reports,” “failure to seek SEC approval to use a satisfactory foreign control location,” “registration violation,” and “inadequate supervisory system and written procedures.” However, the charge that most interests me is “ICBCFS’s AML program was not reasonably designed to detect and cause the reporting of potentially suspicious activity.”
This failure was related to their business with penny stocks: “As described below, during the Relevant Period, the Firm’s AML program was not reasonably designed to detect and report potentially suspicious activity,
including customer trading in penny stocks.”
From the FINRA AWC letter:
In late 2012, ICBCFS added the clearing and settling of equity transactions as a new business line. The Firm began to clear for numerous direct customer accounts and dozens of correspondent clients (the “ introducing broker–dealers”) that introduced over 21,000 fully disclosed DVP/RVP1 and held in custody accounts at ICBCFS. Within a few months of launching the equity clearing business, ICBCFS began clearing and settling the purchase and sale of millions of dollars’ worth of penny stocks.
Despite adding the equity clearing as a new business line, ICBCFS failed to design an AML program that was reasonably tailored to identify potentially suspicious activity, particularly in penny stock transactions. From January 2013 through at least June 2014, the Firm had no surveillance or exception reports identifying potentially suspicious activity involving penny stock liquidations or red flags of potentially manipulative trading, such as (1) purchases and close in time liquidations of large blocks of thinly traded penny stocks, (2) substantial fluctuations in price of thinly traded penny stock shares, and (3) customers who dominated the trading volume in penny stocks. ICBCFS also did not require its employees to document their review of monitoring / surveillance reports that the Firm had in place during the Relevant Period. Nor did the Firm require its employees to document their decisions regarding the filing of SARs.
The Firm failed to track whether customer accounts were related, or determine whether or not account holders were acting in concert to liquidate penny stocks. The Firm also lacked systems and procedures to monitor whether certain activities – including the opening of multiple accounts, wire transfers out of an account, or funds transfers among accounts, each of which would be relevant to evaluating potentially suspicious activity– were unusual for any given customer, despite the Firm’s written AML procedures specifically identifying such items as red flags requiring monitoring.
The Firm’s AML program also was unreasonable in that it assigned a significant number of the Firm’s suspicious activity monitoring functions to a non–existent employee title. The Firm’s written AML procedures delegated the responsibility for investigating indicia of potentially suspicious activity such as the opening of multiple accounts by a single customer, wire transfers from an introduced customer with no apparent business purpose, and transactions inconsistent with a customer’s normal pattern of business to an unnamed employee identified by the title “ Operations Manager.” However, during the Relevant Period the title “ Operations Manager” did not exist at the Firm and no Firm employees effectively carried out the investigation of suspicious activity assigned to the Operations Manager.
The scale of ICBCFS’ penny stock business is impressive (emphasis mine):
During the Relevant Period, Firm customers liquidated more than 33 billion shares of penny stocks and generated approximately $210 million in proceeds. Approximately 15 billion penny stock shares were sold by Firm customer accounts that did not purchase a single penny stock during the Relevant Period. In total, approximately 106 accounts during the Relevant Period sold penny stocks without making any purchases. Liquidations of penny stocks by Firm introduced customers frequently dominated the overall trading volume, resulting in hundreds of instances where such liquidations represented more than 75% of a penny stock’s trading volume in a single day.
The AWC letter gives several examples of suspicious trading, but the anonymous firm “XYZ Financial LLC” takes the cake:
In 2013 and 2014, the Firm opened two accounts for introduced customer XYZ Financial LLC (“ XYZ Financial” ), notwithstanding that the entity’s beneficial owner had been barred from the securities industry in 2012 following a FINRA disciplinary action. XYZ Financial liquidated penny stocks associated with approximately 107 different issuers and generated more than $18 million in proceeds. In approximately 675 instances, XYZ Financial’s liquidations represented more than 50% of the total daily market volume for a given penny stock.
• Over 143 trading days from June 2013 through June 2014, XYZ Financial liquidated more than 3.2 million shares of a thinly traded penny stock without purchasing a single share. On approximately 103 trading days, XYZ Financial’s liquidations exceeded 50% of the total market volume. XYZ Financial generated more than $475,000 from the liquidations. During this period, the price of the stock dropped by roughly 77% from a high of approximately $0.35 per share to $0.08 per share.
• From late October 2013 through March 2014, XYZ Financial liquidated approximately 89 million shares of a different thinly traded penny stock without purchasing a single share. On several trading days, XYZ Financial’s liquidations represented or exceeded 30% of the daily trading volume. During the time period of XYZ Financial’s liquidations, the price of the penny stock dropped by more than 50%. XYZ Financial generated approximately $65,000 in proceeds from the liquidations.
SEC Settlement with ICBCFS
The SEC’s cease and desist order / settlement (pdf) with ICBCFS also relates to SARs on penny stock transactions and only mentions transactions with clients of Chardan:
4. Specifically, during the relevant period, seven of Chardan’s customers sold over 12.5 billion shares of penny stocks. These sales were often in large volumes, constituting a material percentage of the daily sales volume in the security. Each of the seven customers engaged in at least one transaction where the customer’s sales of a particular penny stock accounted for over 50 percent of the sales volume in that penny stock during a single trading day, and four of the seven customers engaged in at least one such transaction where the customer’s sales exceeded 70 percent of the sales volume in a penny stock during a single trading day. Moreover, while not identified by ICBCFS at the time, the liquidations by the seven customers at Chardan frequently occurred where the issuers had ongoing promotional campaigns or had large accumulated deficits.
5. On January 27, 2014, ICBCFS requested that Chardan have a customer stop trading “all these sub penny stocks today.” Despite this prohibition, that customer sold multiple sub-penny stocks after this date. ICBCFS failed to file a SAR related to these transactions and did not produce a written analysis or other records supporting the reasonableness of why a SAR did not need to be filed.
6. On March 18, 2014, ICBCFS asked Chardan for a description of another customer’s sales transactions, indicating that unless it received sufficient information about that customer’s background, it would close the account. ICBCFS closed that account a few days later, but failed to file a SAR related to the customer and did not produce a written analysis or other records supporting the reasonableness of why a SAR did not need to be filed.
7. On June 23, 2014, ICBCFS asked Chardan for more information on two specific transactions by customers trading low-priced securities. ICBCFS failed to file a SAR related to these transactions and did not produce a written analysis or other records supporting the reasonableness of why a SAR did not need to be filed.
8. On June 25, 2014, ICBCFS asked Chardan about ten specific transactions in lowpriced securities. ICBCFS failed to file a SAR related to these transactions and did not produce a written analysis or other records supporting the reasonableness of why a SAR did not need to be filed.
9. On June 26, 2014, ICBCFS asked Chardan about eight specific transactions in low-priced securities. ICBCFS failed to file a SAR related to these transactions and did not produce a written analysis or other records supporting the reasonableness of why a SAR did not need to be filed.
10. On June 27, 2014, a Vice President at ICBCFS told Chardan’s President that ICBCFS had closed certain customer accounts at a broker-dealer specializing in low-priced security trades, and those customer accounts were migrating to Chardan. Three of the accounts listed in the email had opened and begun trading in February 2014, and the fourth had opened and begun trading in October 2013. ICBCFS did not conduct a review of these customers’ trading activities despite flagging these issues. ICBCFS failed to file any SARs related to these transactions or customers and did not produce a written analysis or other records supporting the reasonableness of why SARs did not need to be filed.
11. By late June 2014, ICBCFS effectively ceased clearing transactions in penny stock securities by certain of Chardan’s customers.
ICBCFS was ordered to pay $860,000 to the SEC.
Chardan Capital Markets LLC Settlement with SEC
Chardan Capital Markets’ settlement with the SEC (pdf) relates to the SEC settlement with ICBCFS because it was Chardan’s clients’ trading cleared through ICBCFS that was responsible for a significant portion of the penny stock volume traded through ICBCFS. The FINRA action noted that ICBCFS “firm customers liquidated more than 33 billion shares of penny stocks and generated approximately $210 million in proceeds”. The SEC settlement with Chardan mentions that “seven of Chardan’s customers from the period October 1, 2013 to June 30, 2014 sold over 12.5 billion shares of penny stocks”. So by share volume Chardan clients were responsible for just over a third of penny stock trades at ICBCFS.
From the settlement:
1. Beginning in late 2013, Chardan on-boarded seven new customers who routinely deposited and then promptly sold billions of shares of thinly-traded penny stocks. These customers typically obtained their holdings by converting debentures into shares of microcap issuers. The shares were generally deposited with a custodian and then sold through the customers’ “delivery versus payment/received versus payment” accounts (“DVP/RVP accounts”) at Chardan. The customers engaged in sales that regularly accounted for a substantial percentage of the daily volume in these thinly-traded penny stocks until the customer’s entire position was sold. The sales frequently occurred after or as promotions in the securities were occurring. Those transactions, in light of other information known to Chardan at the time, raised or should have raised red flags for the firm. Given the suspicious nature of its customers’ transactions, related red flags, and the requirements of its written policies, Chardan should have filed SARs on numerous occasions and did not produce a written analysis or other records supporting the reasonableness of why SARs did not need to be filed.
7. Beginning in late 2013 through the first half of 2014, Chardan facilitated the sale of billions of shares of low-priced, thinly-traded penny stocks for seven customers, all of which cleared through a single clearing firm, ICBC. This trading in penny stocks led to a large uptick in Chardan’s commissions from equity trading: in December 2013, Chardan generated just over $235,000 in such commissions, while in January 2013, it generated over $797,000.
8. Specifically, seven of Chardan’s customers from the period October 1, 2013 to June 30, 2014 sold over 12.5 billion shares of penny stocks. These sales were often in large volumes, constituting a material percentage of the daily sales volume in the security. Each of the seven customers engaged in at least one transaction where the customer’s sales of a particular penny stock accounted for over 50 percent of the sales volume in that penny stock during a single trading day, and four of the seven customers engaged in at least one such transaction where the customer’s sales exceeded 70 percent of the sales volume in a penny stock during a single trading day.
9. Despite the explicit requirements of Chardan’s Policies, Chardan failed to adequately investigate suspicious activity as these customers engaged in these sales.
10. These liquidations were coupled with other indicia that should have further heightened suspicion and raised concerns for Chardan. For example, its customers were trading in penny stocks where the issuers had ongoing promotional campaigns or had large accumulated deficits. In other instances, Chardan became aware of additional suspicious transactions or other red flags related to its customers or their accounts subsequent to their suspicious trading. For example:
- After the trades were executed, Chardan received numerous regulatory inquiries concerning certain securities that certain of these seven customers’ effected trading in.
- Chardan discovered past criminal and regulatory issues with an entity with which certain of these seven customers were associated.
- Chardan knew, or should have known, that the Commission suspended trading in three securities after the securities had been recently liquidated by certain of these seven customers.
11. Chardan failed to properly investigate its customers’ already suspicious high volume trading in light of these red flags and never filed a SAR with respect to any of these transactions. This contravened Chardan’s Policies, which required that Chardan investigate suspicious transactions and file a SAR as necessary.
Here are some illustrative transactions from the settlement:
19. In December 2013 and March 2014, Customer A opened two accounts at Chardan controlled by the same individuals. Customer A traded substantial volumes of the daily market in fourteen microcap issuers in these two accounts from December 2013 through May 2014. Of the 165 dates it sold securities, Customer A accounted for over 20 percent of the sales volume on 129 of those dates and over 50 percent of the sales volume on 59 of those dates. In addition to this high-volume trading, which was a red flag of potential money laundering under its policies, Chardan was or should have been aware of a number of additional red flags that should have further raised suspicions concerning Customer A’s trading, including:
- Chardan knew or should have known that eight of the issuers were the subject of promotional campaigns just before or during Customer A’s trading.
- The SEC suspended trading in one of the issuers approximately six weeks after Customer A’s large volume of sales in that security.
- After the trades were executed, Chardan received regulatory inquiries regarding Customer A’s trading in three securities.
In addition, Chardan never questioned the business purpose of the same individuals havingaccounts in two names, despite its policies identifying a single customer having multiple accounts under multiple names as a red flag requiring further investigation.
20. Chardan was also aware that the individuals involved with Customer A were previously associated with an entity that had been charged by the Commission on August 22, 2012, with securities fraud. In that matter, the Commission charged the entity with conducting an unlawful penny stock scheme in which the entity bought billions of stock shares from small companies and illegally resold those shares in the public market. The purported exemption used in the Commission’s action was the same one that Customer A used to conduct certain of its trading at Chardan. The registered representative at Chardan on Customer A’s account contacted management of Customer A who informed him that the individual charged in the Commission’s action, while not a principal or control person of Customer A, was a consultant to Customer A.
Despite knowing this additional fact, Chardan conducted no further investigation into Customer A’s trading and took no alternative actions, such as heightened scrutiny of Customer A’s transactions, as required under the Chardan’s Policies. Further scrutiny of Customer A’s transactions would have shown that it was engaged in the same type of transactions as the Commission had alleged to be fraudulent.
21. Despite the substantial daily volume of trading by Customer A in these securities and the other red flags associated with the transactions set forth above, Chardan never filed a SAR to report Customer A’s transactions and did not produce a written analysis or other records supporting the reasonableness of why SARS did not need to be filed.
Although I cannot be 100% certain, I believe the “entity that had been charged by the Commission on August 22, 2012, with securities fraud,” was E-Lionheart Associates LLC. The litigation release for that case is dated August 23rd, 2012 and the same phrase is used in that litigation release, “bought billions of stock shares from small companies and illegally resold those shares in the public market.” The docket of the SEC suit against E-Lionheart Associates can be found free at CourtListener.com. In summer 2017 the SEC won a summary judgment (pdf) in that case. To be clear, “the individual charged in the Commission’s action, while not a principal or control person of Customer A, was a consultant to Customer A.”
Chardan was ordered to pay a penalty of $1,000,000 to the SEC.
Chardan’s AML officer, Jerard Basmagy, also settled (pdf) with the SEC. He was fined $15,000 and barred from associating with any broker or investment adviser for three years and barred from participating in the offering of any penny stock for three years.
From Basmagy’s settlement:
Despite having policies which set forth red flags of suspicious activities and the requirement to review those red flags, Chardan did not conduct the requisite review of significant penny stock liquidations that occurred through seven customer accounts during the relevant period. Chardan’s clearing firm, Industrial and Commercial Bank of China Financial Services LLC (“ICBC”), raised multiple concerns to Chardan about certain of Chardan’s customers and their trading in low-priced securities. In June 2014, ICBC ceased clearing penny stock trades, and Chardan withdrew from the penny stock business. Chardan also knew, suspected, or had reason to suspect that certain of the seven customers were engaged in fraudulent activity based on other red flags listed in their policies. These included the background and identity of the customers, trading suspensions in certain issuers that were the subject of prior trading by the customers, and numerous regulatory inquiries received by Chardan after May 2014 regarding certain of the customer’s trading. Despite the suspiciousness of its customers’ transactions, the related red flags, and the requirements of its written policies to review those red flags, Chardan never investigated these red flags or filed a SAR during the relevant period related to its customers’ suspicious penny stock transactions.
By failing to file SARs as required, Basmagy, as Chardan’s then CCO and AML Officer, willfully aided and abetted and caused Chardan’s violations of Section 17(a) of the Exchange Act and Rule 17a-8 thereunder.
17. In certain instances, when FINRA staff and the Commission’s staff separately requested any files in the possession, custody, or control of Chardan related to certain transactions in low-priced securities as part of their respective regulatory inquiries and the Commission’s investigation in this case, Basmagy requested that registered representatives contact customers and obtain those documents. Neither he nor any other Chardan employee had previously done so despite the requirements of Chardan’s Policies described in paragraph 12, above. Basmagy then provided the documents to regulatory staff without noting that Chardan obtained those documents only after receiving the request. As a result, the regulatory staff believed that the documents were in Chardan’s files at the time of the transactions when, in fact, Chardan received the documents after the receipt of the regulatory inquiry.
Unrelated SEC settlement with Schwab
On July 9, 2018 the SEC announced a settlement with Charles Schwab for failing to file SARs. See the complaint (pdf). The SARs that Schwab should have filed were not for penny stock transactions but instead for “cherry-picking” and excessive fees charged by advisers. From the complaint:
3. In 2012 and 2013, Schwab violated Exchange Act Section 17(a) and Rule 17a-8 by failing to file Suspicious Activity Reports (“SARs”) on suspicious transactions by independent investment advisers (“Advisers”) that Schwab terminated from its custodial platform. Schwab terminated the Advisers for engaging in activity Schwab determined violated its internal policies and presented risk to Schwab or its customers.
4. Schwab’s failure to file the SARs at issue resulted from its inconsistent implementation of policies and procedures for identifying and reporting suspicious transactions under the SAR Rule (31 C.F.R. § 1023.320(a)). Although Schwab investigated and terminated the Advisers, it did not have clear or consistent policies and procedures regarding the types of transactions on which SARs needed to be filed. For example, Schwab did not file SARs in certain instances where it investigated and terminated Advisers for conduct that led, or reasonably should have led, Schwab to suspect that the Advisers had charged certain customers excessive advisory fees, had allowed their state registrations to lapse, or were engaged in schemes involving “cherry-picking” (a fraudulent trade allocation scheme where the Adviser allocates profitable trades to the Adviser’s personal account and unprofitable trades to client accounts). In addition, in a number of instances where Schwab investigated and
terminated Advisers for conduct that led, or reasonably should have led, it to suspect that the Advisers misappropriated or misused client funds, Schwab applied an unreasonably high standard for determining whether to file a SAR on the suspicious transactions.
From the settlement release:
Schwab has agreed to settle the action by consenting, without admitting or denying the allegations of the complaint, to the entry of a permanent injunction and the payment of a $2.8 million civil penalty.